While picking winning stocks may seem like the key to successful investing, avoiding massive mistakes is equally important. For every stock that treats investors to outsized returns, there are many more that eventually fall apart, permanently wiping out investors' capital in the process. The ability to avoid these disasters is often the difference between average and exceptional investors.
Three stocks in particular -- Arena Pharmaceuticals (NASDAQ:ARNA), Peabody Energy (NYSE:BTU), and Salesforce.com (NYSE:CRM) -- stand out to our Foolish contributors as disasters waiting to happen. Here's why investors should avoid these three stocks.
George Budwell (Arena Pharmaceuticals): While the term "dangerous" might be a tad strong when describing Arena Pharmaceuticals, this small-cap biotech stock is anything but a safe bet. Since launching its FDA-approved weight loss pill Belviq, Arena's shares have shed a staggering 77% of their value, and there is little reason to believe this downward trend will reverse course anytime soon.
The problem is that Belviq is generally only bringing in a little over a million a month in revenue for the company because of sluggish sales, as well as Arena's revenue sharing agreement with the drug's marketing partner Eisai. As a result, Arena had to slash its workforce by 35% last month to start reducing its cash burn.
On the bright side, Eisai is reportedly gearing up for additional commercial launches of Belviq in a handful of ex-U.S. territories, and the Japanese drugmaker is planning on submitting a once-daily formulation for approval with the Food and Drug Administration sometime soon. Unfortunately, it's hard to see how these events will make a major impact on Arena's bottom or top lines in the near term.
That's why management has been attempting to refocus the investing community's attention on the biotech's promising mid-stage product candidates, ralinepag and ADP334. Unfortunately, these experimental-stage drugs are both several years away from even being reviewed by a regulatory agency. Arena thus appears stuck in this slump for the foreseeable future.
Matt DiLallo (Peabody Energy): Coal is dying a slow and painful death because of increased environmental regulations, low natural gas prices, and the steady rise of renewables. Because of these factors, and a debt-laden balance sheet, Peabody Energy is a dangerous stock, and one that really should be avoided.
In the U.S., coal continues to lose its share of the electricity generation market. In 2007, coal generated roughly 50% of the power in the U.S. according to the U.S. Energy Information Administration. However, from the chart below, we can see that it has slowly lost share to gas.
According to the EIA, coal will only generate 33% of America's power in 2015, and worse yet, the current forecast has that number dwindling down to 18% by 2030. Because of this market share erosion, Peabody Energy predicts that utility coal demand in the U.S. will decline by 100 million tons in 2015, with demand expected to decline by another 90 million tons next year.
To make matters worse, not only did Peabody Energy and its peers not see that decline coming, but they misread global coal demand from emerging market economies like China and India. The expectation had been that global demand would be robust because emerging markets needed coal to fuel their economies. This outlook resulted in coal companies taking on large amounts of debt a few years ago to expand. Now that demand has been weaker than expected, the market is oversupplied with coal, and the balance sheets of coal producers are weighted down with debt.
Because of this, many coal producers are in, or on the brink of, bankruptcy. That is a fate Peabody Energy hopes to avoid, but it currently has $6.3 billion of debt it's trying to restructure. That could be a problem after one of its peers recently ran into a big snag with its own restructuring plan, putting Peabody's ability to restructure its debt outside of bankruptcy in serious doubt.
With a dying market and a mountain of debt, Peabody Energy is a dangerous stock. If it can't restructure its debt, bankruptcy might be its only option.
Tim Green (Salesforce.com): Software-as-a-service company Salesforce has provided investors with truly stunning returns over the past decade. The stock has risen by more than a factor of 10 over the past 10 years, giving investors an annualized return of nearly 27%. The company's revenue has soared in that time, as its cloud-based customer relationship management software continues to disrupt the CRM market.
Why is Salesforce a dangerous stock? First, the company's market capitalization has reached an eye-popping $52 billion, nearly 9 times revenue over the trailing-12-month period. Salesforce is growing fast, but not that fast: The company expects revenue to grow by 23% this year, a slowdown compared to previous years.
More troubling is Salesforce's inability to turn a profit. The company has produced a GAAP loss every year since 2011, with revenue growth taking precedence over profitability. Salesforce is cash-flow positive, with free cash flow of $643 million over the past 12 months, compared to a GAAP loss of $101 million during that time. But this discrepancy is driven by the company's heavy use of stock-based compensation, and if you back out acquisitions, Salesforce's adjusted free cash flow has actually been negative over the past five years on a cumulative basis.
The bull argument for Salesforce is that the company will eventually become big enough that it can cut back on spending and start printing cash. But Salesforce already does $6 billion of revenue annually, and while a strategy of growth-at-all-costs seems to be pleasing investors at the moment, Salesforce's lofty valuation is based on little more than hope.
George Budwell has no position in any stocks mentioned. Matt DiLallo has no position in any stocks mentioned. Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Salesforce.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.